IRS restored S corporation status after an inadvertent termination

Plain-English summary

The IRS ruled that a corporation's S corporation election was inadvertently terminated after the corporation had accumulated earnings and profits and more than 25 percent of its gross receipts came from passive investment income for three consecutive years. The corporation's business had been sold, but it retained an installment note and cash reserves, which generated interest income. The corporation and its shareholders had reported their income as though the S election remained in effect, distributed the accumulated earnings and profits, and agreed to make any adjustments required by the IRS. The IRS therefore treated the corporation as continuing to be an S corporation on and after the termination date, unless the election was otherwise terminated.

Ruling snapshot

• Question: Could the corporation continue to be treated as an S corporation after its election was inadvertently terminated by passive investment income and accumulated earnings and profits?
• Outcome: Approved
• Key authorities: IRC §§ 1361(a), 1361(b), 1362(d)(3), and 1362(f); Treas. Reg. § 1.1362-4

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201025033 Third Party Communication: None
Release Date: 6/25/2010 Date of Communication: Not Applicable
Index Number: 1362.04-00
Person To Contact:
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------------------------- Telephone Number:
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---------------------------------------- Refer Reply To:
CC:PSI:3
PLR-144459-09
Date:
March 12, 2010

                                                LEGEND

Company = -----------------------------------------------

Shareholders = ----------------------

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PLR-144459-09 2

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Date1 = -----------------------

Date2 = -----------------

Date3 = ----------------------

Year1 = -------

Year2 = -------

Year3 = -------

Year4 = -------

State = ----------------

Dear ------------:

    This letter responds to your letter dated September 21, 2009, and subsequent

correspondence, submitted on behalf of Company, requesting a ruling under § 1362(f)
of the Internal Revenue Code.
PLR-144459-09 3

                                     FACTS

   Company incorporated in State on Date1. On Date2, Company filed Form 2553,

Election by a Small Business Corporation, effective Date2. At the time of its S
Corporation election, Company had accumulated earnings and profits leftover from the
years it was a C corporation. In Year1, Company sold its operations to a third party.
Company received an installment note for a portion of the purchase price. In addition,
Company maintained its corporate existence, and kept the note and cash reserves in an
escrow account in Company’s name. This was required by the buyer to insure against
any unforeseen liabilities for which Company would have been responsible.

   On Date3, Company inadvertently terminated its S election pursuant to

§ 1362(d)(3). Specifically, in Year2, Year3 and Year4, Company had no earnings other
than interest income from the note and escrow account holdings that existed after the
sale of its business operations. In addition, in Year2, Year3, and Year4, Company still
had accumulated earnings and profits that had carried over from the time it was a C
corporation.

    Company represents that there was no intent to terminate Company’s S

corporation election and that the combination of passive income and accumulated
earnings and profits was inadvertent and not motivated by tax avoidance or retroactive
tax planning. For all taxable years, Company and Company’s shareholders’ reported
income consistent with Company qualifying as an S corporation. Moreover, since the
time it discovered the termination, Company has distributed all of its earnings and
profits to its Shareholders in proportion to their shares. In addition, Company and
Company’s shareholders agree to make any adjustments consistent with the treatment
of Company as an S corporation as the Secretary may require with respect to the period
specified by § 1362(f).

                             LAW AND ANALYSIS

    Section 1361(a)(1) provides that the term “S corporation” means, with respect to

any taxable year, a small business corporation for which an election under § 1362(a) is
in effect for such year.

   Section 1361(b)(1) defines a “small business corporation” as a domestic

corporation which is not an ineligible shareholder and which does not (A) have more
than 100 shareholders, (B) have as a shareholder a person (other than an estate, a
trust described in § 1361(c)(2), or an organization described in § 1361(c)(6)) who is not
an individual, (C) have a nonresident alien as a shareholder, and (D) have more than 1
class of stock.
PLR-144459-09 4

   Section 1362(d)(2)(A) provides that an election under § 1362(a) shall be

terminated whenever (at any time on or after the 1st day of the 1st taxable year for
which the corporation is an S corporation) such corporation ceases to be a small
business corporation.

   Section 1362(d)(3)(A)(i) provides that an election under § 1362(a) shall be

terminated whenever the corporation (I) has accumulated earnings and profits at the
close of each of 3 consecutive taxable years, and (II) has gross receipts for each of
such taxable years more than 25 percent of which are passive investment income.

   Section 1362(d)(3)(C)(i) provides that except as otherwise provided in

§ 1362(d)(3)(C), the term “passive investment income” means gross receipts derived
from royalties, rents, dividends, interest, and annuities.

    Section 1362(f) provides, in relevant part, that if an election under § 1362(a) by

any corporation was terminated under § 1362(d)(2) or (3); (2) the Secretary determines
that the circumstances resulting in such ineffectiveness or termination were inadvertent;
(3) no later than a reasonable period of time after discovery of the circumstances
resulting in such ineffectiveness or termination, steps were taken so that the corporation
for which the termination occurred is a small business corporation; and (4) the
corporation for which the termination occurred, and each person who was a shareholder
of the corporation at any time during the period specified pursuant to § 1362(f), agree to
make the adjustments (consistent with the treatment of the corporation as an S
corporation) as may be required by the Secretary with respect to this period, then,
notwithstanding the circumstances resulting in termination, the corporation shall be
treated as an S corporation during the period specified by the Secretary.

    Section 1.1362-4(b) of the Income Tax Regulations provides that for purposes of

§ 1.1362-4(a) the determination of whether a termination was inadvertent is made by
the Commissioner. The corporation has the burden of establishing that under the
relevant facts and circumstances the Commissioner should determine that the
termination was inadvertent. The fact that the terminating event was not reasonably
within the control of the corporation and was not part of a plan to terminate the election,
or the fact that the event took place without the knowledge of the corporation,
notwithstanding its due diligence to safeguard itself against such an event, tends to
establish that the termination was inadvertent.

   Section 1.1362-4(d) provides that the Commissioner may require any

adjustments that are appropriate. In general, the adjustments required should be
consistent with the treatment of the corporation as an S corporation during the period
specified by the Commissioner.

                                  CONCLUSION

PLR-144459-09 5

   Based solely on the facts submitted and representations made, we conclude that

Company's S corporation election was terminated on Date3, the first taxable year after
three consecutive years in which Company had accumulated earnings and profits, and
also in which more than 25 percent of its income was passive activity income. We
further conclude that the termination was inadvertent within the meaning of § 1362(f).
Pursuant to the provisions of § 1362(f), Company will be treated as continuing to be an
S corporation on and after Date3, unless Company's S corporation election is otherwise
terminated under § 1362(d).

   Except for the specific ruling above, we express or imply no opinion concerning

the federal tax consequences of the facts of this case under any other provision of the
Code. Specifically, we express or imply no opinion regarding Company's eligibility to be
an S corporation.

    Under a power of attorney on file with this office, we are sending a copy of this

letter to your authorized representative.

  This ruling is directed only to the taxpayer who requested it. According to

§ 6110(k)(3), this ruling may not be used or cited as precedent.

                                   Sincerely,

                                   /s/

                                   Leslie H. Finlow
                                   Senior Technician Reviewer, Branch 3
                                   Office of the Associate Chief Counsel
                                   (Passthroughs & Special Industries)

Enclosures (2)
Copy of this letter
Copy for Section 6110 purposes